Considering gold’s outstanding fundamentals, it’s no surprise that
demand has stayed strong a decade into its bull. And with demand
only expected to strengthen in the years to come, a lot of weight
rests on the shoulders of gold’s suppliers.

In
order for this yellow metal to find an economic balance, consumers
rely on a supply chain that had been quite consistent over the
years. The major supply sources of mine production, recycling, and
central-bank sales had worked in symphony to meet demand.
Unfortunately over the course of gold’s bull this supply chain has
grown increasingly inconsistent and unreliable, with these sources
exhibiting extreme volatility.

Supply from central-bank selling has been the most volatile of the
major sources of recent. According to respected research
house/consultancy GFMS, CB sales averaged between 400 to 500 metric
tons (mt) per year from 1989 to 2007. Over this long span the
world’s monetary authorities geared their reserve biases towards
fiat currencies, and consistently dumped gold onto the market.
These gold sales had thus become a reliable source, accounting for
about 10% to 20% of global supply.

But
with the recent travails in the global financial markets, CBs
quickly realized the folly of their ways. Countries suddenly
started to worry about their own currencies, and others they held as
foreign reserves. All the meanwhile gold was gaining more and more
recognition as the global reserve currency it had always been, and
it suddenly became a legitimate hedge to the gamut of fiats.

As a
result, the consistent and reliable gold supply from CB selling
faced serious peril. Many CBs decelerated or outright halted their
selling. And provocatively some went against the grain, and
actually started buying. Per GFMS tracking data of net CB
buying/selling activity, 2008 sales were slashed in half to just
over 200mt. 2009 followed with another huge haircut, coming in with
marginal net sales of less than 50mt. And then in 2010 CBs were
actually net buyers of gold for the first time in over 20
years.

With
this astonishing change of events not only did gold’s supply chain
completely lose a big source, CBs had joined the consumer ranks and
were now competing for gold. And this trend is expected to
continue. Already in Q1 2011, CBs had purchased more gold
(estimated 129mt) than in all of 2010!

So
with supply from central-bank sales completely gone, gold’s other
major supply components have had no choice but to pick up the
slack. And thankfully some upside volatility on the recycling front
has helped fill the gap in recent years. In the beginning of gold’s
bull, recycling accounted for about one-quarter of supply. But
thanks to the allure of higher gold prices, recycling has
skyrocketed to where it now accounts for about 40% of supply.

Indeed higher gold prices have prompted folks to work harder to
extract scrap gold from spent equipment/electronics. And there has
been a huge surge in people recycling their old jewelry. But
interestingly this increased selling on the jewelry front is
somewhat of an unsustainable phenomenon, and will likely reach a
point of exhaustion in the very near future.

Anybody who watches television and listens to the radio has
experienced the bludgeoning of ads by companies that wish to take
unwanted gold off your hands. You can also open your local
newspaper and find out about the nearest gold party. Show up to one
of these with your friends, and you can dish your gold to an
opportunist host while enjoying cocktails and hors d’oeuvres.

The
problem is this surge in recycling has coincided with a brutal
recession. Many of the folks cashing in their gold are desperate
for money to pay their bills and feed their families. And it won’t
take long for this desperation selling to be exhausted. Most people
interested in selling their gold have done so, and it is likely that
the gold coming in from this channel will see a decline in the
coming years.

So
with no more CB supply and what is likely to be a softening in
recycling, this leaves the supply chain resting firmly on the
shoulders of mine production. Yet even this reliable gold supplier
has experienced volatility of its own as you can see.

Mine
production has always been the primary source of gold, responsible
for about 60% of supply in recent years. And leading into gold’s
bull, which officially commenced in 2001, mine production had been
pretty consistent. Through 2003 the miners had delivered at least
2500mt of gold per year for five years running.

But
you’ll notice that in 2004 mine production took a dive, down by over
6% in a single year. And this was the beginning of a tailspin that
saw production fall by a staggering 12.7% over five years.
By 2008 the miners were producing at levels not seen since the
mid-1990s. Yet over this same period the price of gold had more
than doubled.

This
trend was of course quite alarming, and gave additional fundamental
support to gold’s already-powerful bull market. It was also
perplexing that this type of trend was even possible considering
gold’s upward momentum. With the price of gold surging past record
highs, you’d think the miners would do everything in their power to
boost volume. And that perhaps even the droves of new miners would
start making material contributions. Yet seven years into gold’s
bull, the miners were unable to answer the call.

There are many explanations for this huge production decline, but
ultimately it came down to a systemic issue in the gold-mining
industry. Simply put, this decline was a direct product of the bear
that preceded the current bull.

During those cold dark years of the late 1980s and 1990s, the low
gold prices forced the miners into survival mode. And those that
did survive focused their efforts on the operations side of the
business, working to optimize and expand their existing
mines. With low margins and a lack of investor interest, they just
didn’t have the financial bandwidth to explore for new deposits and
develop new mines.

This
prolonged exploration lull resulted in a lack of discoveries, and
thus reserve renewal. And the lull in development put the
gold-mining industry way behind the curve in grooming the next
generation of mines. As clearly demonstrated in the chart above,
this lack of activity resulted in serious consequences.

As
mature mines deplete their reserves, they are either shut down or
shift to the mining of lower-grade ore, which naturally drops
output. This normally isn’t a problem if new mines are built at a
fast-enough pace to cover the shortfall from mature mines. But
without a strong pipeline of next-generation mines to cover the
shortfall, it doesn’t take long for aggregate production to see a
material decline.

Fortunately in the midst of this production decline, the gold miners
were working hard to stop the bleeding and right the ship. This
bull’s higher gold prices and higher stock prices allowed them to
finally put capital to work exploring and developing. And the
result has been an increase in discoveries and a ramp-up of mine
builds.

But
just as the damage from the previous exploration cycle had a lagging
effect that permeated well into this bull, it’s taken many years for
the current exploration cycle to get ahead of the depletion curve.
It takes a lot of time, and money, to get from discovery to
production. Finally in 2009 we started to see the fruits of the
current exploration cycle, and over the last two years we’ve seen
production grow by an impressive 10.6% to an annual volume of 2500mt
(per the U.S. Geological Survey).

This
recent growth is of course the good news, but the bad news is mine
production is still down nearly 3% bull to date. And in the
face of growing demand and weakness from the other supply sources,
this is a huge problem. These miners have now had a decade to ramp
up production, and the fact that they are not yet at par indicates
there is still a structural problem. The natural lag in getting new
mines from this exploration cycle online is one thing, but there is
more than meets the eye in this struggling industry.

There’s no question that gold mining is a tough business. And as
time goes on, it only gets tougher. Gold is a rare precious metal
for a reason, with its occurrence in economic lodes fleeting.
Miners have accepted that the low-hanging fruit is gone, which has
forced them to get creative in tapping the lower-grade and
higher-complexity ores. But this geological conundrum is only one
of many challenges the miners are faced with.

Miners are also subject to operational risk on a variety of
different levels. And let’s not forget about geopolitical risk.
Greedy governments want a bigger piece of the pie, unionized labor
is more costly than ever, regulatory requirements are increasingly
stringent, and misinformed environmentalists have too much pull with
the bureaucrats.

So
what does this mean for the future of mine production? Well
according to most experts, it’ll continue to be a tough and volatile
road. Gold miners will continue to operate in a growingly-hostile
environment. And in all likelihood they will be hard-pressed to
collectively meet growing demand in the years to come.

Thankfully the big increase in supply over the last couple years has
taken off some pressure in the interim. But folks shouldn’t get too
comfortable with this outsized rate of growth. This impressive run
is in large part a result of the long-awaited commissionings of a
handful of mega mines, which are not annual events.

Overall the gold industry’s infrastructure is still on the mature
side, which will require a lot of new mines to come online in order
to cover the shortfalls from depleting mines in the coming years.
But even at these higher prices, this is easier said than done. In
fact, even with this recent sharp production growth there are still
rumblings that the world has seen or will soon see a peak in gold
production.

I
personally don’t buy into this theory for a variety of reasons,
notwithstanding the fact that 2011 might deliver record mine
production. The reality is if the price is right, over time the
miners ought to be able to deliver at any demand level. There’s a
lot of gold in the ground that may not be economically feasible to
extract at $1000, but sure would be at $2000 and higher.

Regardless of the challenges, the fact is if the demand for gold
continues to climb, the miners simply must rise to the occasion.
And with gold’s
long-term fundamentals still wildly bullish, we should expect
demand growth to put continual supply pressure on the mining
industry for years to come.

From
an investor’s point of view, of course gold should continue to be a
top performer. And as any seasoned trader knows, adversity presents
big opportunities. The real gains should still reside in the stocks
of the elite miners that are capable of successfully exploiting the
supply side of the gold market.

The
world’s biggest and best gold miners have enjoyed quite a run over
the last decade. And their stocks have greatly leveraged gold’s
performance, rewarding investors with legendary gains. Measured by
the venerable HUI gold-stock index, bull-to-date leverage of about 3
to 1 has delivered 1500%+ gains for these stocks!

But
provocatively even though these secular numbers are great,
gold-stock investors haven’t been feeling the love in recent years.
In fact, many will argue that these miners’ stocks have been dogs
over this stretch. And indeed there’s something to this gold-stock
disdain.

Interestingly prior to 2009 the HUI had positively leveraged gold at
a clip of about 5 to 1. But seven long years of positive leverage
in this ballpark has been quickly throttled when you consider the
performance of the miners relative to gold since. And the last 18
months in particular have been simply dreadful. In 2010 with gold
up 30% and the HUI up 33%, there was only 1.1 to 1 leverage. And so
far in 2011 with gold up 6% and the HUI down 9%, the only
leverage is to the downside.

This
lack of positive leverage is indeed an alarming trend, one that has
long-time gold-stock investors and speculators scratching their
heads. 2008 was of course the year of the
Great Stock Panic,
and also coincidentally the year mine production hit its low. Did
the stock panic thwart this leverage? Has mine production growth
the last couple years numbed investors’ sensitivities to the
importance of gold miners? Who knows! What we do know is that gold
stocks used to be the hottest sector in all the markets, and now it
seems as though they’ve lost their glitz and glamour.

So
are the olden days of big positive leverage gone? On a corporate
level as measured by the HUI, perhaps. Even prior to the stock
panic leverage was
declining in individual gold uplegs. And one major reason for
this is many of the miners that constitute this index have gotten so
big that their size alone makes it difficult to push big gains.

That
being said, the larger stocks still ought to deliver positive
leverage based on their inherent risk. 5 to 1 was heavenly, 3 to 1
is fantastic, and even 2 to 1 would likely be enough to entice
traders into gaming the gold stocks. But 1 to 1 and/or
underperformance is unacceptable. No wonder investors have been
shying away!

At
Zeal we think the recent gold-stock performance is an anomalous
enigma. And that gold stocks even measured by the HUI will regain
positive leverage to gold. But considering the circumstances, we’re
likely entering into more of a stock-picking environment rather than
all-gold-stocks-to-the-moon like before. The miners still have to
mine gold, it’s just a matter of picking those that will thrive in
the process.

There are many more gold stocks today than at the beginning of the
bull, and investors just can’t expect any handful of stocks to
outperform gold anymore. But those stocks that hold the right
deposits and operate with the right margins should greatly
outperform, and ought to deliver excellent leverage.

At
Zeal we pride ourselves in hand-picking elite gold stocks that are
well-positioned to capitalize on this bull. As a result of expert
research and timely
trading, the average annualized gains of all gold-stock trades
realized in our newsletters in 2010 was +79%. Vastly better
than what was offered by the HUI!

And
while we’ve stayed away from gold stocks for the most part so far in
2011, we plan on redeploying in the coming months as
technicals/fundamentals dictate. Hopefully we’ll see returns akin
to last year! To find out what and when we are trading on top of
cutting-edge market analysis,
subscribe to our
monthly and/or
weekly
newsletters today!

The
bottom line is global gold supply has undergone a radical shift in
recent years. Central-bank selling has ceased amid a global
financial crisis, recycling has surged as opportunists take
advantage of the higher gold prices, and mine supply has bounced all
over the place as the bear/bull exploration cycles have their
effects on the market.

And
for reasons mentioned above it is mine production that will be the
key component of gold’s economic balance going forward. This source
has and will be the primary supplier of gold, and investors should
be able to continue to ride the miners to profit in this bull.
Prudently hand pick a custom portfolio of great gold stocks, and
legendary gains can still be won.